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In 1968, a financial economist from NYU named Edward Altman developed a model for

assessing and probabilistically predicting corporate bankruptcy. The formula, known as

the Z-score model, was partly unique because it used a previously questionable

methodology: multivariate analysis. As Altman notes in his July 2000 paper revisiting

the model, the questions to ask once we accept this reasoning are as such: (1) which

ratios are most important in detecting bankruptcy potential, (2) what weights should

be attached to those selected ratios, and (3) how should the weights be objectively

established.

Rather than bogging down in the methodology (interested parties can read the paper

in the link at the bottom of this article for an in-depth explanation), lets move forward

to the conclusion of the research, and how it set the basis for the Z-score. After

evaluating the selected companies, the model Altman developed was as such (in

Altmans original analysis, this included 66 corporations with 33 firms in each of two

group. The bankrupt (distressed) group (Group 1) is manufacturers that filed a

bankruptcy petition under Chapter X of the National Bankruptcy Act from 1946

through 1965 Group 2 consists of a paired sample of manufacturing firms chosen on

a stratified random basis.):

earnings before interest and taxes/total assets, X4 = market value equity/book value

of total liabilities, X5 = sales/total assets and Z = overall index; the zones of

discrimination were as such:

The explanation (and accompanying notes from Altman) for the variables are as

follows:

X1 measure of the net liquid assets of the firm relative to the total capitalization.

Working capital is defined as the difference between current assets and current

liabilities. Liquidity and size characteristics are explicitly considered. Ordinarily, a firm

experiencing consistent operating losses will have shrinking current assets in relation

to total assets. Of the three liquidity ratios evaluated, this one proved to be the most

valuable. Two other liquidity ratios tested were the current ratio and the quick ratio.

There were found to be less helpful and subject to perverse trends for some failing

firms.

An important side note here is to watch out for inventory's impact on current assets; a

low, quick ratio and inventory with slow turn is a bad combination.

via corporate quasi-reorganizations and stock dividend declarations. While these

occurrences are not evident in this study, it is conceivable that a bias would be

created by a substantial reorganization or stock dividend and appropriate

readjustments should be made to the accounts. The age of a firm is implicitly

considered in this ratio. For example, a relatively young firm will probably show a low

RE/TA ratio because it has not had time to build up its cumulative profits. Therefore, it

may be argued that the young firm is somewhat discriminated against in this analysis,

and its chance of being classified as bankrupt is relatively higher than that of another

older firm. But, this is precisely the situation in the real world. The incidence of failure

is much higher in a firms earlier years. In 1993, approximately 50% of all firms that

failed did so in the first five years of their existence. In addition, the RE/TA ratio

measures the leverage of a firm. Those firms with high RE, relative to TA, have

financed their assets through retention of profits and have not utilized as much debt.

The manipulation of retained earnings can generate misleading results, with the

classic example being Microsofts (MSFT) negative retained earnings due to dividend

payouts. Make sure to note when these instances appear and adjust your data

accordingly.

X3 This ratio is a measure of the true productivity of the firms assets, independent

of any tax or leverage factors. Since a firms ultimate existence is based on the

earning power of its assets, this ratio appears to be particularly appropriate for studies

dealing with corporate failure. Furthermore, insolvency in a bankrupt sense occurs

when the total liabilities exceed a fair valuation of the firms assets with value

determined by the earning power of the assets. As we will show, this ratio continually

outperforms other profitability measures, including cash flow.

From my perspective, X3 is the only stand-alone operating measure in the model, and

shows the capacity to which a firm can escape the trappings of X1, X2, and X3,

which are balance sheet items; a strong performance in X3 figures will often be how

the remaining variables are improved over time.

X4 The measure shows how much the firms assets can decline in value (measured

by market value of equity plus debt) before the liabilities exceed the assets and the

firm becomes insolvent. It appears to be a more effective predictor of bankruptcy than

a similar, more commonly used ratio; net worth/total debt (book values).

X5 This final ratio is quite important because it is the least significant ratio on an

individual basis. In fact, based on the univariate statistical significance test, it would

not have appeared at all. However, because of its unique relationship to other

variables in the model, the sales/total assets ratio ranks second in its contribution to

the overall discriminating ability of the model.

As Altman notes, Over the years many individuals have found that a more convenient

specification of the model is of the form: Z = 1.2X1 + 1.4X2 + 3.3X3 + 0.6X4 +

1.0X5. The reason is due to screwy input methodology for the original model, which

could easily cause user error and result in inaccurate and useless outputs.

To date, the model has proven successful at indicating potential issues; at the time of

writing, Altman had this to say: In repeated tests up to the present (1999), the

accuracy of the Z-Score model on samples of distressed firms has been in the vicinity

of 80-90%, based on data from one financial reporting period prior to bankruptcy.

However, there is one glaring problem with the results it is suggested that the ZScore model is an accurate forecaster of failure up to two years prior to distress and

that accuracy diminishes substantially as the lead time increases.

Personally, I think the applicability of the model extends beyond the output and (as a

corollary) the zone the firm falls into. I believe that by breaking down the model into

its individual parts, you are given a picture of what is creating the financial distress at

the company (if any); when you chart the results over a couple of quarters/years, you

are also given a timeline of how the variables have transformed over time. With these

pieces in hand, you can assess how the firm must adjust their capital structure or

operating results to continue as a going concern.

Definition

Z-Score model is an accurate forecaster of failure up to two years prior to distress. It can be considered the assessment

of the distress of industrial corporations.

Columbia Pipeline Partners LP's Altman Z-Score for today is calculated with this formula:

Z = 1.2

= 1.2

* X1

+ 1.4 * X2 + 3.3 * X3

* -0.099 + 1.4 * 0

+ 0.6 * X4

+ 1.0 * X5

+ 1.0 * 0.1624

= 0.72

* All numbers are in millions except for per share data and ratio. All numbers are in their own currency.

Trailing Twelve Months (TTM) ended in Sep. 2014:

Total Assets was $7,262 Mil.

Total Current Assets was $378 Mil.

Total Current Liabilities was $1,097 Mil.

Retained Earnings was $0 Mil.

Pretax Income was $419 Mil.

Interest Expense was $-38 Mil.

Revenue was $1,179 Mil.

Market Capitalization (Today) was $2,638 Mil.

Total Liabilities was $3,362 Mil.

X1

= Working Capital

/ Total Assets

/ Total Assets

= (378.1 - 1097.3)

/ 7261.8

= -0.099

X2

X3

X4

X5

Retained Earnings

Total Assets

7261.8

Total Assets

Total Assets

(419.3 + -37.9)

7261.8

0.063

Market Capitalization

/ Total Liabilities

2638.290

/ 3361.9

0.7848

=

Revenue

Total Assets

1179.4

7261.8

0.1624

Distress Zones - 1.81 < Grey Zones < 2.99 - Safe Zones

Columbia Pipeline Partners LP has a Z-score of 0.72 indicating it is in Distress Zones.

Study by Altman found that companies that are in Distress Zone have more than 80% of chances of bankruptcy in two

years.

Explanation

X1: The Working Capital/Total Assets (WC/TA) ratio is a measure of the net liquid assets of the firm relative to the total

capitalization. Working capital is defined as the difference between current assets and current liabilities. Ordinarily, a firm

experiencing consistent operating losses will have shrinking current assets in relation to total assets. Altman found this

one proved to be the most valuable liquidity ratio comparing with the current ratio and the quick ratio. This is however the

least significant of the five factors.

X2: Retained Earnings/Total Assets: the RE/TA ratio measures the leverage of a firm. Retained earnings is the account

which reports the total amount of reinvested earnings and/or losses of a firm over its entire life. Those firms with high RE,

relative to TA, have financed their assets through retention of profits and have not utilized as much debt.

X3, Earnings Before Interest and Taxes/Total Assets (EBIT/TA): This ratio is a measure of the true productivity of the

firms assets, independent of any tax or leverage factors. Since a firm's ultimate existence is based on the earning

power of its assets, this ratio appears to be particularly appropriate for studies dealing with corporate failure. This ratio

continually outperforms other profitability measures, including cash flow.

X4, Market Value of Equity/Book Value of Total Liabilities (MVE/TL): The measure shows how much the firms assets

can decline in value (measured by market value of equity plus debt) before the liabilities exceed the assets and the firm

becomes insolvent.

X5, Revenue/Total Assets (S/TA): The capital-turnover ratio is a standard financial ratio illustrating the sales generating

ability of the firms assets.

Read more about Altman Z-score and the original research.

Be Aware

Z score does not apply to financial companies.

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